Inflation still on the agenda for the Fed

19th June 2014 By: Eimear Daly

June FOMC Meeting – 18/06/14

Events yesterday were a clear example of market expectations overshooting the outlook for monetary policy. Thursday’s US CPI shot higher to 2.1 per cent, which was above target and the third consecutive gain for the index. This whiff of inflation meant many market participants went into the Fed meeting with a clear hawkish bias.

The heavily anticipated economic projections were mixed, with GDP growth sharply downgraded, unemployment target range downgraded and inflation range slightly upgraded. Even the controversial dot plot was less than clear-cut. While members brought forward the timing for the first rate hike, rate hikes would now be slower with a lower long-run interest rate.

Considering the market’s hawkish bias going into the meeting, the sharp downgrade in GDP outlook and the FOMC’s comfort in overlooking above target inflation, the outcome may seem moderately dovish. However, the market may have downplayed how hawkish this Fed meeting actually was. Yellen admitted in the Q&A that the US’s potential growth rate may be lower for some time and this is certainly backed up by the downgrade in the Fed’s view of the long-term interest rate. Although the Fed also saw the economy as rebounding after the slow winter, the housing market was a notable exception to this.

The slack in the US economy isn’t as great as previously thought, meaning the emergence of inflation is a lot closer. Thanks to the Fed’s aggressive QE policy there are trillions of excess reserves in the US system, and as soon as we get some return of money velocity, inflation will be back.

The trade-weighted US dollar initially popped higher on the release as the markets scrambled to decipher the dot plot, but gradually settled and reached a monthly low in the morning session. The US 10-year yield was pressed further to below 2.6 per cent and the US 2-year fell to just 0.43%.

US yields are now pricing in less than two hikes in the next two years, fuelling concerns that the US money market and US dollar are now underpricing the risk of policy tightening if inflation picks up. We expect the first increase in the Fed Funds Rate in mid-2015, but further increases will, as the Fed persistently repeated, be slow and gradual with a lower termination rate.